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The dangers of pension lump sums

28th June 2018

Since April 2015, people with private pension funds have had far more freedom about what they can do with their “pot” and many more people are taking advantage of this. Click here to see video.

For example, one can now take the whole pension as a lump sum without having to buy an annuity or similar long-term investment.  So, the pension fund holder has more freedom to choose an investment that suits them.

But, although (generally) a quarter of the pot can be taken as a tax-free lump; anything above that is taxable income – and will be added to other taxable income in the same tax year.  This could push total taxable income well into the Higher Rate tax band.  So, it is vital that sensible tax planning takes place.

There is a danger that uninformed people will take the whole pension fund out as a lump sum, and then find that a big part of it will be taxed at the Higher Rate of income tax – 40%; whereas if they had taken the pension out over a number of years, they could find it is only taxed at 20% tax.

It would be a great shame if, after years of carefully putting aside money into a pension, one effectively gives an extra 20% of a large chunk of the pension fund straight to the Government for the want of some simple planning. 

For example, if a pension pot of £100,000 is cashed in by someone with other taxable income of about £20,000, then perhaps £25,000 of the pension pot would be the tax-free amount; about £20,000 will be taxed at 20%, and; about £55,000 will be taxed at 40%.  With a bit of patience and some planning, much of this tax can be avoided.